America's potential GDP

Remembering when the future kept getting bigger

HOW big can the American economy grow? This week's Free exchange column tackles the critical question of America's potential: the maximum output it can sustain given its endowments of capital, labour and technology.

The article notes that economic growth since the recession ended three years ago has averaged 2.5% a year. That is roughly the trend rate of an economy already at full employment. Given that America is still in a deep post-recession hole, such a rate should not be enough to reduce unemployment, and should have left so much spare capacity that inflation ought to have fallen sharply. Instead, unemployment has dropped nearly two percentage points in that time and underlying inflation, after dipping below 1%, is above 2%.

While various idiosyncratic factors can explain this behaviour, it could also be a sign that the crisis has significantly eroded potential GDP, and the output gap is much smaller than generally realised. (This is a topic on which I've blogged before, here, here and here.) Since 2005 the Congressional Budget Office has revised down its estimate of potential GDP in the year 2012 by 5%.

Doing this exercise for the late 1990s, a completely different picture emerges. As the accompanying chart shows, in 1997, the CBO estimated potential in early 2001 would be $8.3 trillion (in constant 1996 dollars). By 2001, it had revised that up a whopping 12%, to $9.3 trillion, a figure that looks more reasonable given what we now know GDP actually did.

The CBO's shifting estimates of potential illustrate two things. One is that potential is almost impossible to pin down in real time since the economy's equilibrium long-run stock of capital and labour are so difficult to estimate with precision; so we look at what GDP actually did as a hint of what it can do.

Second, and more important, is that supply (i.e. potential) is itself affected by demand. Potential output is the product of capital, labour and innovation. Since economic booms bring more investment, more risk-taking, and higher labour force participation, they push up measures of potential. The opposite is true of busts. If overall spending is depressed long enough, many workers will experience prolonged unemployment that degrades their skills, making them unemployable; they may eventually quit the labour force altogether. Depressed sales also discourage investment in new technology and research, which can degrade productivity and efficiency for years to come. (A counter argument is that depressions may hasten the migration of capital and labour from dying, low-productivity sectors to growing, high-productivity ones. Apparently, scholars are still arguing over whether this happened in the 1930s.) Powerful evidence for this phenomenon comes in a paper that my colleague A.C.S. discussed Monday which found most structural unemployment begins during recessions.

It follows that efforts to preserve demand can also preserve the economy's supply-side potential. That, too, seems to be one of the lessons of international experience. It is not too late for America to limit most of the long-run damage of its crisis; but it may soon be.

(Note: special thanks to Brent Moulton of the Commerce Department's Bureau of Economic Analysis for technical advice on how to convert real GDP figures to a common base year.)

"It follows that efforts to preserve demand can also preserve the economy’s supply-side potential. That, too, seems to be one of the lessons of international experience. It is not too late for America to limit most of the long-run damage of its crisis; but it may soon be."

Yup, but the GOP has no interest in doing anything to improve the economy until November, and then only if Romney wins.

When Republicans attack the stimulus as ineffective, they undercut the prime article of their faith, for much of it was tax cuts. There is always the risk that some fiendish Democrat may point this out, and sow doubt among the as-yet unconfirmed.

In theory, their must be a point where the U.S can no longer grow as it is at maximum capacity. One thing I cant get my head around is the idea that any economy can continue to grow FOREVER...it's ridiculous...america and the world is only so big.

The Soviet model was not different from Marx's model. That's a lie Marxists made up to keep the USSR from discrediting Marxism. Marx was very vague about the details of implementing socialism because he was less concerned about building his socialist utopia than in tearing down capitalism. The USSR was the best implementation of Marx's ideas ever.

The other day somebody was shouting about US sovereign debt and noted that it was up around 126% of GDP and how if he ran his family finances like that, he'd be living on the street. Normally I just tell myself that sovereign debt is different than personal debt. But got to thinking, well, if I made $100k a year and went to the bank with $26k in car loans and credit card debt and wanted to borrow $100k on a house, that would probably be no problem at all. I would even imagine that it is not all that unusual in many parts of the country to have a mortgage or total debt of more than three times yearly income.
Not that I think there is no problem, or that we shouldn't start reducing debt, but there is also the argument that confidence works both ways.
To take the Ron Paul extreme, (though the mainstream party is getting out there too) if I went to see a banker about refinancing and borrowing a bit more on a mortgage so that I could build an addition for my aging mother, and was calm and collected and had a plan then I would expect it would work out. If I went in rending my hair and gnashing my teeth and bewailing my financial incompetence, and then informed the banker that I wasn't all that much into the whole fiat dollar thing and asked if he would except organic chickens like my papa used to barter back in Texas, then I would expect that the extra cash would not be forthcoming.

Your utopian society can only exist if it has no competition.
Wealth creation by individuals and localised capitalist enterprises is the only way forward as world charity and neo marxist African states have failed so badly.
The average African peasant farmer is worse off than his grandfather because of centralised govt interference contrasted with the market system his ancestors enjoyed.
Localised capitalism with a light benign State works -- Marxism does not

Most people recognize that structural unemployment happens when specific skills are no longer in demand and workers need to be retrained. What they don’t see is that the same thing happens to capital equipment. Just as work skills become obsolete due to changes in the economy, so capital equipment dedicated to those same jobs becomes obsolete. It’s difficult to make pizzas with equipment used to make cars.

Capital and work skills become obsolete when consumer preferences change. Consumer preferences changed in the latest crisis when consumer could not or would not borrow to continue living beyond their means.

Much of the equipment and plants used to make cars and stuff for housing are now obsolete in an economy that demands far fewer of each. The loss of that capital reduces the potential output of the economy. So projecting potential output from the peak of output during the latest unsustainable boom is just stupid.

Nations are indeed different - they have vast quantities of liquid debt mutualised over diverse income steams.

Yet, that doesn't make the situation prettier. Government tax income isn't 100% of GDP.

Actually, 2011 tax revenue was 32% of GDP. Sure, debt at "3x annual income" sounds modest. But American federal and state governments have vast spending obligations across Medicare, pensions, payroll, the military, maintenance of infrastructure, bailing out banks, etc. Government expenditure is running at 40% of GDP. "Government liabilities" properly measured would be a very large multiple of GDP.

There's no pretending this is sustainable - the American fiscal deficit is worse than Greece's. The only saving graces are America's sheer economic scale, its lower starting debt levels and fewer structural shocks - but America will require a vast and painful fiscal correction - probably sooner than anyone would want from an aggregate demand perspective.

2) Income tax to be graded to income – the more an individual earned, the more they paid. The less you earned, the less you paid.

3) Abolition of all rights of inheritance.

4) The confiscation of all property of immigrants and rebels.

5) The centralisation of all credit into the hands of the state by means of a national bank with state capital and an exclusive economy.

6) Centralisation of all means of communication and transport into the hands of the state.

7) The extension of factories and the instrument of production owned by the state. Bringing into cultivation all land not being used that could be and an improvement in the fertility of the soil.

8) The equal obligation of all to work and the establishment of an industrial and agricultural armies.

9) The combination of agriculture and manufacturing industries with the gradual abolition of the distinction between town and country by the more equable distribution of the population over the country.

10) Free education for all children in public schools. The abolition of child labour in factories; an educated child would be better for society in the long term, than a child not educated.

The US hasn't abolished private property because that angers the middle class, so it has gone the route of German socialism and taken control of property without taking the paper title. That fools people into thinking they still own the property.

But there's no consumer if there's no employees in your model. The cicle of capital must begin again indefinitely. For capital in it's global picture, there's no difference between a thousand middle class people spending US$ 1 million dollars in 100,000 different itens and 1 person spending US$ 1 million in the same 100,000 itens. For these other 1,000 people can die of inanition as long as it can continue to begin it's cicle again.

For a individual capital to continue to grow, it must extract more value from the lesser workforce possible. The most viable way is through automation: a machine lays off x workers because it can do their work. But by extracting more value from less salaried workforce, it increases it's profit at the cost of the new unemployed and by the relative empoverishment of the few ones that retained their jobs (they now receive the same salary, but produce more for the capitalist): that's why we produce food for 9 billion people but more than 1 billion suffers from hunger. The creation of wealth is the creation of misery.